In a fractional reserve system, banks are only required to hold a portion of their deposits. In the US they're required to hold about 10%. They can loan out the other 90%. That loan has to go somewhere and that somewhere is a bank. Sure, you think of it as going to the guy you're buying that house/car/boat from, but it's really going to their bank account. And once it arrives in that bank account, 90% of it is loaned out. The upshot of this is that $1 creates about $9 more dollars in loans.

Let's say there are $10 in assets at our bank—$1 of reserves and $9 from loans. What exactly happens if there are $2 of defaults? The banks reserves of $1 are wiped out, but then what? Call in the other loans? Declare bankruptcy? Ask congress for a bailout?

What happens to the Federal Reserve when the rate of defaults on mortgages and other debt exceeds the reserve ratio?